Starting a new business is a thrilling time. As exciting and fun as it is, however, it can also be tremendously painful and challenging. To give yourself the best chance at long-term success, you must think through all the possible outcomes of your business. One of these particular challenges in the early phases is determining the right legal structure for your business. Not only is there a variety of entity types to choose from, but each one possesses its own rules, tax treatment, and filing requirements. The truth is, there’s no one-size-fits-all. Instead, you need to compare each option side-by-side to determine which structure gives your business the most advantages in the long-term. In this article, we explain the differences between each entity type and cover important considerations to help you determine the right legal structure for your business.
The Different Entity Types
A sole proprietorship is the simplest, most straightforward legal structure for your business that you can choose. A sole proprietorship is NOT considered a separate legal entity. Instead, “it simply refers to a person who owns the business and is personally responsible for its debts,” according to. As a result, if your business runs into financial trouble, creditors can bring lawsuits against you and your assets. In other words, no corporate veil exists for protection.
All you need to do to set up a sole proprietorship is to register your trade name and secure any required local licenses. Since there is no entity separation between the business and the owner, the sole proprietor reports all profits and losses on their personal income tax return.
Sole proprietor income also qualifies for the new qualified business income deduction of up to 20%. The only added reporting requirements are a Schedule C (profits and losses) and Schedule SE (self-employment tax) along with the personal tax return (Form 1040).
Partnerships require at least two or more individuals and include two different types: general partnerships and limited partnerships.
General partnerships assume that all partners agree to share in all profits and losses and all financial and legal obligations of the business. General partners possess “agency powers,” meaning “any partner can enter into a binding agreement, contract or business deal that all partners are obliged to adhere to,” according to Investopedia. Also, all partners possess unlimited liability. In other words, their personal assets are liable to the partnership’s obligations, and any partner can be sued for the entirety of the business’s debts or assets.
In limited partnerships, at least one of the partners is considered a general partner and is responsible for the day-to-day operations of the business. This general partner is treated the same as a general partner in a general partnership as described above. The remaining partners are considered limited or silent partners, and they contribute capital but do not make any managerial decisions.
As a result, they also benefit from limited liability, meaning they are only liable for the business’s debts up to the amount of capital that they contributed. Profits and losses flow through to the partners’ personal tax returns as specified by the terms of the partnership.
Neither type of partnership provides full protection (unlike other entities) of partners’ personal assets from the business’s creditors. Both types of partnerships typically require very little paperwork or registration fees to be paid to set up.
Limited Liability Company (LLC)
As a legal structure for your business, LLCs provide the most flexibility of all the different entity types in terms of how they are structured and the level of legal protection they provide. LLCs can be set up as either a Single-Member LLC, a Partnership LLC, or a Corporation LLC. All offer at least some degree of protection from personal liability for the business’s debts.
Single-Member LLCs consist of, as the name implies, only one member. If Single-Member LLCs do not elect taxation as a corporation, they are considered by the IRS to be “disregarded entities.” In other words, they are disregarded as a separate entity from the owner (read more at IRS.gov). As a result, they are treated as sole proprietorships in that all profits and losses of the business flow directly to the owner’s personal tax return but with the added benefit of personal liability protection from the business’s debts.
It’s important to note, however, that Single-Member LLCs do not offer as robust of personal liability protection as the other LLC structures. Due to their “disregarded entity” status, a court has legal authority to overturn the liability protection the LLC otherwise offers. The Single-Member LLC tax-filing process is identical to a sole proprietorship.
Partnership LLCs consist of at least two or more partners. Profits and losses flow through to the partners’ personal tax returns according to their specified ownership percentage (equity) in the company. This type of LLC offers full personal liability protection to all partners, both from the business’s debts and any wrongdoing from other partners or employees. Partnership LLC taxes require filing a Form 1065, U.S. Return of Partnership Income.
That information then flows onto a Schedule K-1, which shows a partner’s share of income, deductions, credits, etc. Each partner then uses their Schedule K-1 for their personal tax return (1040) and pay self-employment tax on their share of partnership earnings. Partners are subject to self-employment tax and federal/state income tax.
Corporation LLCs have the option to choose from two different corporation taxation structures as either a C Corporation or an S Corporation. Standard corporate tax rules apply to both, which we’ll cover in the corporation section below.
A corporation is considered a completely separate entity from its owners. As a result, the corporation itself possesses legal rights aside from the owners. These rights include the ability to sue, be sued, own/sell property, and sell ownership in the corporation in the form of stock. There are five main types of corporations:
- C Corporations: Owned by the shareholders and taxed at both the corporate and personal level (also called “double taxation”). Shareholders can be managing partners, employees, or investors. The distributions of profits may be in the form of dividends (capped at 15% for most individual taxpayers). Owners are also capable of receiving compensation for services rendered in their capacity as an employee, which is considered w-2 income (see S Corporation explanation below).
- S Corporations: Structured more like partnerships or LLCs in that they are owned and operated by the owners or partners only and provide limited liability protection. Single-Member and Partnership LLCs can elect taxation as an S Corporation. S Corporations require the business to pay its owners (aka employees) “reasonable compensation” in the form of a W-2 salary. Since this is W-2 income, it is subject to payroll taxes and ordinary income tax. In addition to their W-2 income, owners can also take “owner distributions” from the business profits. These distributions qualify for the qualified business income deduction and are only subject to ordinary income tax (as opposed to self-employment tax as well).
- B Corporations: Also known as benefit corporations, which is more of a certificate or designation than an actual tax or legal structure for your business. Benefit corporations are for-profit businesses, but with charity at their core. For example, the famed outdoor gear label, Patagonia, is a certified B Corporation because of their focus on being environmentally friendly as well as their financial support of other environmental charities. B Corporations receive no special tax benefits for the designation. Instead, taxation follows the legal entity initially selected. There are other negatives as well. B corporations are subject to audits, which means the potential loss (and credibility) of the designation. A B corporation status is also not available everywhere. It is recognized nationally, but not at every state level.
- Closed corporations: “Generally..smaller corporation[s] that [elect] close corporation status and [are] therefore entitled to operate without the strict formalities normally required in the operation of standard corporations,” according to Entrepreneur.com. They are corporations whose shareholders and directors can choose to operate as a partnership, and they can elect taxation as either a C or S Corp. Closed corporations are therefore also subject to double taxation, potentially excessive tax filings for various types of income and other taxes that might be paid, and could also potentially operate the business without any real oversight from the owners if there are not many investors with majority interest.
- Nonprofit corporations: Everyone is familiar with nonprofit corporations. They are as the name implies – not-for-profit. They are designed to help others in some way and are not subject to taxation at all as a result. The downsides to nonprofits are that they can only be used for limited purposes (e.g., charity). Nonprofits are also prohibited from contributing to political campaigns and are limited in the amount of lobbying they may do. Lastly, nonprofits are subject to much more public scrutiny than for-profit companies since their public is for the benefit of the public.
Cooperatives are merely private companies that are owned and controlled by the customers who shop for their products, supplies, or services. They can vary in type and membership size, but they’re all designed to meet the specific objectives of its members. You’ll often find cooperatives amongst local grocery stores.
In Seattle, for example, they have the largest consumer-owned food-cooperative in the United States called PCC Community Markets. It has over 58,000 members, operates twelve retail locations, and does over $277.6 million in revenue per year.
Their focus is to support local, organic farmers, invest back into the community, advocate for quality food, and protect generations of farmland. As a result, they only carry locally sourced organic products.
Essential Considerations in Choosing the Legal Structure for Your Business
Picking the right legal structure for your business from the get-go is extremely important, as it can be quite challenging to change once you’ve already registered your business. You’ll need to think about both short-term needs and concerns as well as long-term growth and big-picture vision. Below, we cover some of the most important of these.
If you are bootstrapping your business with practically nothing, you don’t want to make setting up your legal entity difficult, costly, or time-consuming. With sole proprietorships, partnerships, and LLCs being the easiest, quickest, and least expensive to create, it would make more sense to choose one of these over a corporation.
Do you have a lot of personal assets potentially at stake? Are you going into a high-risk industry, such as financial services or manufacturing, that could easily open the door to getting sued even if you did nothing wrong? You need to consider what level of personal asset protection you need before you open your doors.
Where do you see your business going in five years? Ten years? Fifteen years? Will you be hiring employees or bringing in new partners? If you want to incentivize your employees, you might want to structure as a corporation so you can issue stock as additional compensation. If you are planning to bring in new equity partners, you might want to structure like an LLC.
Corporations require double taxation, meaning the business pays taxes, and the owner pays taxes. This structure can be challenging to manage in the early years of a company before you’re even profitable. LLCs provide pass-through income so that you can avoid this double taxation.
They also offer the ability to deduct up to 20% of their income from taxation at all. Understanding what makes sense from a tax perspective will dictate much of your choice in legal structure.
With sole proprietorships or LLCs, you’re the owner AND operator of the business. You’re in complete control of what happens day-to-day in your company and the direction in which it heads. With corporations, they’re required to have a board of directors that make significant decisions that guide the company’s direction.
The owner may be that board of directors in the early stages, but as it grows, it needs to operate the business more as a board-directed entity. Knowing what level of control you desire long-term will help you decide which legal structure makes the most sense.
If you plan or need to bring on investors at some point, you’ll likely want to structure your business as a corporation right from the get-go. As a corporation, you can more easily issue ownership stakes in your company to those investors in the form of stock. LLCs, on the other hand, may be required to use their own personal credit or assets to secure outside investments.
Depending on what industry you are in or the location of your business, you may require additional licenses or permits to operate. There may also be other regulations and further steps to take as a result.
Hopefully, you have a better understanding now of the options available to you in choosing the right legal structure for your business. If you have additional questions or questions specific to your situation, please don’t hesitate to reach out or schedule a time to chat.
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